The terms "positive and negative gearing" are commonly talked about topics. This article explains what these terms mean, the advantages and disadvantages of each investment and how it works within your investment strategy.
Before selecting a property to invest in it is important to consider whether that property best suits your current investment strategy. An important way to determine whether a property is suited to you is to understand whether it is a Positively Geared (Cash-flow Property) or Negatively Geared (Capital Growth Property).
In this article, we will compare the two types of properties by explaining how it works and the advantages and disadvantages involved. This will then help you to form a better idea of what may suit your investment strategy.
What is a positively geared property?
Positive gearing occurs when you receive more in rent from your tenants than what you pay on the likes of loan repayments, interest, property maintenance and rates. This tends to happen at times when rents are high due to strong demand and interest rates are low.
This type of investment is often referred to as a ‘cash flow property’ as the property is putting additional money into your pocket.
For example, a property that costs $400,000 located in an area where availability is limited and rental prices are high may have a rental return of $590.00 per week. The repayment costs are only $457.00 per week therefore this property is increasing your income by $133.00 per week and in turn is paying for itself. In this situation, the property is positively geared.
Increased income - you benefit by receiving an income from the property and not having to be out of pocket. You can even use this income to make additional payments into your mortgage and own your home sooner!
Not as much risk - if your income circumstances changes e.g. if you were to lose your job then the income will cover the costs of the investment and you are less likely to need to sell under pressure and potentially unfavourable conditions.
Balanced portfolio - some investors may use a positively geared property to balance their portfolio, using the additional income to pay the shortfall of negatively geared investments.
Lender Attractiveness - the additional income can increase your attractiveness to lenders for additional loans.
Taxable - just like any form of income, the income you earn on a positively geared property is taxable.
Slower long-term growth - often but not always, a positive cash flow investment can be located in a regional area (rather than capital cities), which commonly (but not always) see less or slower capital growth. Dual income properties can often be located in capital growth areas but also provide cash-flow.
More volatile - these properties may be largely dependent on a particular industry of employment which can make it subject to greater volatility should employment factors weaken.
What is a negatively geared property?
A negatively geared investment exists when the rental income you receive is less than the costs of owning the property. Often referred to as ‘capital growth properties’, negatively geared investments are expected to appreciate in value over time and this increase is expected to outweigh any short-term financial losses. These properties are commonly located in areas closer to capital cities which typically perform better over the long term.
For example, a property that costs $400,000 located in a high growth, stable area, most likely near a capital city where rental yields may be lower, the rental return may be a more affordable amount of $420 per week and therefore does not fully cover repayment costs of $457.00 per week and you have a short-fall of $37.00 per week. In this situation, the property is negatively geared.
Tax Deductions - a common reason investors choose this strategy is that it allows you to claim tax deductions related to the expenses you incur. So by claiming the available tax deductions you can reduce your rental short-fall and ultimately reduce your taxable income.
Capital Growth - assuming the strategy goes to plan, the capital returns from the property will eventually outweigh the borrowing levels and costs to create wealth for the investor at sale.
More affordable for tenants - because of the affordability, it can be easier to secure a tenant for the long term.
Less volatile - unlike a property in a regional area which may rely heavily on particular employment industries to drive up demand, these properties rely on a variety of factors and can be a less volatile investment.
Budgeting is needed - you need to be able to budget for the ongoing shortfalls. Also when the property is sold for a profit, the tax man collects on the capital gain.
Long-term strategy - it’s a longer term wealth creating strategy so if your circumstances change and a sale is necessary the sums may not work out favourably.
Higher financial risk - if in the instance you were to lose your job you will need to be able to maintain any costs involved. Make sure you have a plan in place to ensure you are prepared. For example, income protection and insurance policies.